The Fed Messed Up

Includes: RINF
by: The Angry Bear

By Edward Lambert

This post will build upon my previous post with the Cobra equation. In that post, I gave a model showing that the Fed is completely behind the curve of the business cycle. The Fed should not be raising rates at this point in the business cycle.

When To Normalize In Theory

In the model, aggregate profit rates have a somewhat circular movement through a business cycle. I say somewhat because in other business cycles, the circular movement looks more like a bouncing ball off of the effective demand limit.

In the green portion of the cycle, aggregate profit rates are increasing. There is broad momentum to expand the utilization of labor and capital. It is the best time for interest rates to get on a path to normalization. The economy can withstand the good medicine of normalizing interest rates because of the momentum of increasing profit rates.

If US interest rates are too low or too high in the green area, global imbalances will grow to some extent. In the present business cycle, inflation and the labor market looked weak, interest rates were kept low. Even though the economy seems weak and fragile in the green area, the underlying profit momentum drives economic developments and possibly imbalances. Normalizing interest rates are meant to moderate those imbalances.

So the Fed decided not to normalize interest rates because the economy seemed weak and partly because economists like Paul Krugman said the Fed needed to wait for inflation. But global debt accumulated, even emerging market debt, because interest rates were not normalizing in the US.

The accumulated debt is a problem that hinders growth. Apart from there just being more debt, much of the debt in emerging markets is in US dollars. So if interest rates are normalizing in the US, there is a control over too much US dollar debt developing in emerging markets. That is a good thing, because now we see greater problems as the cycle begins to tighten with monetary policy and peaked profit rates.

Also in hindsight, the increased use of US dollars in emerging markets is a problem now that commodity prices are falling. As well, the devaluation of the Chinese Renminbi may have occurred earlier in a more balanced way if the US had been normalizing interest rates earlier.

So What Has The Fed Done?

This graph seeks to show that the Fed should have been normalizing interest rates in the green area when there was the momentum of increasing aggregate profits rates. The "global" economy would have had better discipline, better balance in order to not create cyclical debt imbalances in US dollars (cyclical means that at a certain point in the business cycle, the imbalance becomes a problem).

Moreover, the efficiency of the US economy would have been greater. Higher interest rates imply more productive companies and consequently better net social benefits, as long as the interest rates are normalizing with the profit rate cycle and with a correct estimate of the real natural rate.

The generally accepted normalized rate for the Fed rate is between 3% and 4%. We are far from there. The Fed should have been normalizing rates in the green area, and certainly not in the red circle... as it has done. It is completely behind the curve.

With aggregate profit rates peaked for over a year now, it is clear that the business cycle has peaked. So from what I see, the Fed has really messed up, even Paul Krugman. It seems to think that the economy is still within or arriving at the green area of the business cycle.

Now is absolutely the wrong point in the profit rate cycle to be normalizing rates. In a normal cycle, this would be the time that interest rates peak or even fall, but not rise. The Fed can tip the economy into recession.

As I have said before, the Fed will go through some deep soul-searching... as things will not turn out well for it.

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